1. Structural incentives and their impact on the informal economy Peter Goliaš Institute for economic and social reforms (INEKO), Slovakia November 13, 2012 Chisinau, Moldova

2. Shadow economy and cycles Informal economy is often a substitution of the safety net and/or a buffer between unemployment and regular employment In growing economy: – People move from unemployment to both regular and informal employment – There is no clear pattern about moving from informal to formal employment (it probably depends on other factors, e.g. rules, repression, social capital) In recession: – Informal employment falls if unemployment rises (informal workers get unemployed)

3. Rules verzus repression Informal economy involves mainly low-earners Bad rules => strong motivation of people with low income to stay informal, for example due to high tax/administrative burden If you fight shadow economy with repression and you have bad rules, you risk harming the economy (they might get unemployed) Usually with bad rules there is limited repression: – Politically it is inconvenient to punish low-earners – There is room for free-riders (e.g. rich speculants) Conclusion: Rules (motivation) first, repression second

4. Key rules (structural incentives) Tax system: – Tax burden: Tax wedge, Marginal effective tax rate (METR) – Tax mix: Labor, capital, consumption, real estate – Tax administration (capacity, complexity, corruption) Income-dependent social benefits Labor market: – Employment protection (e.g. restrictions on dismissal) – Active and Passive interventions (Unemployment trap) – Labor Union power, Minimum wage Link between contributions (social insurance) and benefits Bureaucracy, market competition, etc. Caution: Even good rules may not work if there is low level of social capital and weak institutions

5. Obstacles to doing business

6. Tax system – problems Key problem in Central and Eastern Europe – High taxes on labor (especially at low earnings): – Mainly due to social insurance contributions – Firms and workers often face trade-off between compliance and survival – Leibfritz (2011): Relatively low formal salaries, together with relatively high taxes on labor, may explain why in the new members of the EU undeclared work often takes the form of under-declaration of income through payment of part of registered workers’ wages in cash or through false registration of workers as self-employed. – Formal employment does not decline, but government revenues are lower

7. Tax system – problems Other problems: – A combination of high taxes on labor and low taxes on capital can induce individuals to transform labor income into capital income to reduce their tax burden. – Where the effective tax burden is lower for the self- employed than for dependent workers, workers may shift—voluntarily or coerced by employers—from dependent employment to self-employment. – The tax treatment of families may encourage secondary earners to work informally if additional formal income is taxed at a high marginal rate. – Ineffective tax administration (complexity, corruption)

8. Tax system complexity

9. WB Doing Business 2013 MoldovaRomaniaSlovakiaGermanyUSA Ranking109.136.100.72.69. Payments (number per year) 484120911 Time (hours per year) 220216207 175 Total tax rate (% of profit) 31.244.247.946.846.7 Paying taxes

10. Social insurance ”productivity”

11. Tax wedge Definition: – Difference between labor costs and the take-home pay of workers – (Social insurance contributions paid by employers and employees + Personal income tax paid by employees) / (Total labor costs) Depends on family type and wage level For a single person with no children who receives a gross wage 33 percent of the average wage, only a few EU-15 countries—including Sweden, Germany, Belgium, and Finland—charge higher taxes than most of the EU’s new member states

12. Tax wedge for low-earners

13. Tax wedge – progressivity

14. Formalization tax rate (FTR) For individual, turning from informal to formal employment means: – Loss of tax wedge – (At least partial) Loss of income-tested benefits: Social assistance, housing benefits, in-work and family benefits – Gain of social insurance benefits: Old-age and disability pension, health insurance, unemployment and sickness benefits, employment protection, etc. Definition of FTR: – The share of informal income that an informal worker has to give up to formalize – [Informal income (informal wage + social benefits) - Formal net income (formal net wage + social benefits)] / Informal income

15. FTR in selected countries Interpretation: For example, in Bulgaria, single persons with no children who earn less than the minimum wage in the informal sector have to give up from 50% to 70% of their income to formalize.

16. FTR peaks

17. Marginal effective tax rate (METR) Definition: – The METR measures, at a given wage level, how much of an additional euro earned in formal gross wages is taxed away, either as labor tax or in the form of withdrawn benefits. – It is an indication of how much it pays for workers to earn more gross income, either by increasing work hours or receiving higher wages. The new EU members tend to have high METRs— usually 100 percent—at low wage levels

18. METR in selected countries Interpretation: In the Czech Republic and Slovenia, every additional euro earned in formal income is 100% taxed away through withdrawal of social assistance at wage levels below 20% of the average wage. In Portugal, it is only 50% and in the US even less.

19. Overall picture 1/3

20. Overall picture 2/3

21. Overall picture 3/3 Regression analysis on microdata shows that the levels of both the FTR and METR have a strongly significant, positive correlation with the probability that a worker is engaged informally In other words, greater individual disincentives to formal work (as measured by FTR and METR) correlate strongly with higher probabilities of being informal The tax wedge yields a negative correlation with informality; the tax wedge is lowest with low-wage earners and increases with income level Caution: Causality cannot be established using cross- sectional data

22. Employment protection

23. Contribution-benefit link The effect of strengthening the link depends critically on whether workers perceive the link between contributions today and benefits far in the future to be strong and credible (e.g. it depends on credibility of institutions).

24. Health insurance Most important from among social insurance entitlements in regard of their influence on informal economy People feel immediate threat of falling sick Easy access to free health insurance decreases motivation to work formally Entitlements to free health insurance should be: – Limited to the poor – Based on a means test, not an income test nor a formal employment status (such as registered unemployment) States should build a robust means-testing mechanisms (or their proxies, e.g. based on electricity consumption, or frequent contact with a social worker)

25. World Bank recommendations Apply tax incentives for low-wage earners „Smooth“ marginal effective tax rates (e.g. flat tax) Remove minor taxes (e.g. heritage, gift taxes) and minimize exemptions and loopholes Shift taxes away from taxing labor earnings to VAT or progressive real estate taxes Integrate collection and auditing of taxes and social insurance contributions Automate administrative processes and interactions between the tax authorities and taxpayers (e.g. electronic payments)

26. World Bank recommendations Reward formal work; any additional formal wage should increase net income, including benefits; the withdrawal of benefits has to be gradual Adopt the “flexicurity” approach of protecting people rather than protecting jobs Tie social insurance benefits closely to contributions (plans with primarily redistributive objective should be shifted to general taxation) Provide free health insurance only to the poor people, based on a means-testing (alternative is a narrower definition of health coverage package) Keep low ratio of minimum/average wages

27. Reform examples 1/5 Slovak flat-tax reform from 2003/04: – Decrease in direct income taxes (to 19% for individuals and businesses), increase in indirect consumption taxes (19% VAT) – Radical simplification of tax code (no exemptions, no minor taxes) – Tax deductible (people with low income do not pay income taxes) – Tax bonuses for children (parents pay lower taxes or, with too low income, they get money back from the state – negative tax)

28. Reform examples 2/5 Germany Hartz IV reform (in effect from early 2000s): – Monthly wages less than €400 are not subject to social insurance contributions – For monthly incomes between €401 and €800, the contribution rate rises gradually to the full share

29. Reform examples 3/5 USA: Refundable tax credits (the “earned income credit” and the “making work pay” credit) are available to low-wage earners and their families: – For a U.S. taxpayer with one child, 34 percent of earned income up to US$9,000 is refundable, which amounts to the equivalent of a cash benefit of about US$3,000 – This refundable credit is phased out at incomes above US$16,000 – Similar benefits are available for other family types and single persons earning low incomes

30. Reform examples 4/5 Denmark’s renowned “flexicurity” model: – Shifts protection away from jobs to the people who lose employment – Low costs of hiring and firing employees – Intensive deployment of active programs such as retraining and job search assistance

31. Reform examples 5/5 Chile introduced a mixed system of unemployment insurance in 2001: – Individual saving accounts are underpinned with a risk-pooling safety net – Employers and workers are required to pay into accounts, and when workers leave or lose employment, they can draw on a specified portion their accumulated savings – Should a person’s job search extend longer than five months, they receive a defined minimum unemployment benefit

32. Sources In From the Shadow: Integrating Europe’s Informal Labor, Policy Research Working Paper 5923, World Bank, Washington, DC., September 2012 – Background paper: Leibfritz, W. 2011. “Undeclared Economic Activity in Central and Eastern Europe: How Taxes Contribute and How Countries Respond to the Problem.” The World Bank Doing Business Reports 2010-13 Author’s thoughts and experience

33. Thank you for attention.